A Lesson for the Ages: If You Can’t Beat Them Join Them –

Because U.S. citizens working abroad do not have the luxury of escaping U.S. self-employment taxation by forming a foreign entity and because no special exemptions exist for overseas companies, the techniques available for avoiding U.S. self-employment taxation are the same for self-employed individuals working abroad as they are for self-employed individuals working inside the United States. Self-employed individuals working abroad should turn their attention to forming a U.S. entity, such as an S corporation.

A popular technique for the small businessperson to avoid self-employment taxation is to form an S corporation in which he is the sole shareholder and employee. The shareholder-employee then draws his money out of the corporation in the most tax advantageous manner possible: as dividends, instead of wages. Thus, the shareholder-employee’s share of S corporation income consists entirely of dividends. Because dividends are not self-employment income, they are not subject to self-employment tax. Therefore, self-employment taxes are avoided.

Unfortunately, the IRS has cracked down on small business compliance with the payroll tax regime. In doing so, it has successfully recharacterized dividend payments made to S corporation shareholder-employees as wages, subject to employment taxes.

The conclusion to be drawn from the IRS’s success in dividend recharacterization cases is this: simplistic planning no longer suffices for even small businesses. With the current crisis in tax compliance and the looming insolvency of the United States Social Security system, the IRS is demonstrating that it will no longer ignore such “small fry.” Utilizing what opportunities still exist to cut down on payroll taxes may mean the difference between the survival and death of a small business. Fortunately, diverse methods still exist for a small business that may tip the balance toward survival.

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